Debate heats up on how to fix Europe's banks

When Dexia collapsed earlier this week, many noted that the Franco-Belgian bank was among those that passed Europe's stress tests this summer and that its meltdown was proof of the inadequacy of that exercise.

PARIS — When Dexia collapsed earlier this week, many noted that the Franco-Belgian bank was among those that passed Europe's stress tests this summer and that its meltdown was proof of the inadequacy of that exercise.

Dexia's failure became a rallying point for those who had argued that banks need to be recapitalized — that is, they needed to be forced to hold more cash on hand to absorb unexpected losses.

That idea had been floating around before Dexia's failure, but the bank's collapse seems to have galvanized officials behind the plan. In recent days, the EU Commission President Jose Manuel Barroso, the Germans and eventually even the French have come out in support of some sort of recapitalization of the banks.

It is now widely expected to be part of the plan to save the eurozone that officials have promised by month's end and details could emerge as early as this weekend at the G-20 finance ministers meeting in Paris.

But all along, there has been another narrative of Dexia. Some, including the French government and the bank itself, noted that Dexia was a special case and that its demise was related to its unusual reliance on short-term loans to fund itself, while primarily lending money out on a long-term basis.

In other words, Dexia had a liquidity, or cash-flow, problem: It had to pay its creditors daily, but its borrowers paid back over a much longer period.

That explanation has been trotted out by many banks over the past few weeks — especially French ones, which have periodically seen runs on their stocks amid concerns they don't have enough capital to withstand a Greek default or major losses on Italian or Spanish bonds.

They say they do have the capital to get through such events and that the banking sector's problem is rather a growing nervousness about lending to one another. If only they could persuade their peers to lend as they normally do, they'd be fine, the banks say.

Because that isn't happening, many of them have had to turn to the European Central Bank as a lender of last resort to get their hands on the short-term loans they need to keep business running. Those short-term loans are far larger than their capital buffers, so having bigger cash reserves doesn't solve their liquidity problem.

In fact, the banks have complained that forcing them to keep more money stashed away for a rainy day will only exacerbate their liquidity problems: If they have to sit on money, then they won't be able to use it to fund their daily operations, or to lend it to their peers.

There are also concerns that it could have effects on the so-called "real economy" if banks pull back on lending to normal consumers such as businesses and households.

The heads of five German banking associations warned officials against exaggerating the need banks have for new money. To do so might create "self-fulfilling prophecies that deepen the crisis," they said in a letter dated Wednesday.

So who's right? Do European banks have a solvency problem, meaning they need more capital, or do they just lack liquidity?

According to Nicolas Veron, both. But it all stems from not having enough capital to withstand the inevitable losses on Greek and other sovereign debt.

At base, "it's a solvency issue," said Veron, who is a senior fellow at the Brussels-based economic think tank, Bruegel. "The liquidity issue is all about trust. And trust will not return unless you have stronger balance sheets in Europe generally."

But the answer is not merely to raise the required "capital ratio" — the amount of total capital banks have as compared to the riskiness of their assets. To pass the stress tests, banks needed a 5 percent capital ratio; now some officials are suggesting it might rise to 9 percent.